I’m a tax lawyer based in San Francisco (www.WoodLLP.com), but I handle tax matters everywhere. I enjoy untangling a tax mess from the past, disputing taxes with the government or planning taxes for the future. One of my specialties is advising about lawsuit payments. Whether you’re receiving or paying a legal settlement, you can probably improve your tax position. I write frequently about taxes, from expatriation to sales tax, from selling your company to restitution. I’ve written over 30 tax books, but my best seller is still Taxation of Damage Awards and Settlement Payments. Contact me at wood@WoodLLP.com.

When Estates Don't Pay Tax, IRS Chases Beneficiaries

When you inherit money or property you shouldn’t have to pay taxes. It’s not subject to income tax. Plus, if there’s an inheritance tax to pay, the estate or person giving it to you has already paid it or provided for its payment.

At least that’s how it’s supposed to work. But what if it turns out the estate tax was not paid, or there’s an audit and the estate owes more? That’s what happened to Anna Smith’s four children after she died in 1991. See U.S. v. Mary Carol S. Johnson.

The executors filed a federal estate tax return showing her estate was worth $15,958,765, with a federal estate tax liability of $6,631,448. But the estate elected a ten-year installment payment of the tax due, a choice that’s available when certain conditions are met.

(Photo credit: Tax Credits)

The bulk of Anna Smith’s estate was stock in Stateline Hotel worth $11,508,400. When the estate distributed the stock, the beneficiaries had to sign an agreement acknowledging that some of what they received would later have to go for taxes. They would pay their share, they agreed.

Three years later in 1995 the IRS sent a bill to the estate claiming the hotel stock was not worth $11.5M but rather $15M. The estate eventually settled with the IRS and agreed to pay additional estate tax of $240,381. That brought the total estate tax to $6,871,829. Still, the estate was liable for it and was going to pay in installments.

Unfortunately, in January 2002, the hotel went bankrupt and its stock became worthless. In 2003, after having paid $5M of the total amount due, the estate defaulted on its tax debt. Did the IRS say OK? Nope, it came after the heirs for the rest.

Can you be personally liable as a beneficiary? Yes. Section 6324(a)(2) of the tax code lists six ways you can be on the hook. Several big ones: “transferee,” “trustee,” and “beneficiary.”

The IRS argued the heirs were transferees, but the transferee statute only covers transfers immediately after death, not later as occurred here under a trust agreement. Then the IRS said they were beneficiaries, which they clearly were. Under a technical reading, though, the court ruled they were not liable under this provision.

What’s more, the court ruled that the IRS was too late to collect from most of the heirs since the statute of limitations had run. The only ones the IRS could pursue were the two heirs who had acted as personal representatives. Under 31 USC 3713(b), a representative of an estate that pays an estate’s debt before paying the IRS is liable if the government doesn’t get its due.

Thus, if an estate has insufficient assets to pay its debts, a personal representative must pay the IRS first. If he doesn’t, the personal representative has personal liability. Here, the two contended they didn’t know the assets were insufficient.

After all, everything looked rosy when they handed out the stock. The bankruptcy came later. But the court said that was tough.

You can reach me at Wood@WoodLLP.com. This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.

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